Menu
Tax Notes logo

Lien Interest in Insurance Proceeds Differs from Interest in Property Itself

Posted on Sep. 10, 2020

In the case of Wolinsky v. Frye, No. 19-01009 (Bankr. D. Vt. 2020) the holder of a second mortgage competes against the IRS for the insurance proceeds resulting from a fire at the taxpayers’ home. Even though the IRS had subordinated its lien to the second mortgage holder on the home, it argues that with respect to the insurance proceeds, the federal tax lien and the equitable lien of the mortgage holder attach simultaneously, giving the IRS a victory over the insurance proceeds. The bankruptcy court agrees.

This case involves more than one lien issue. The first issue presented by the case is the subordination of the federal tax lien to the second mortgage. This does not often happen. The opinion gives few facts about the subordination but states that the IRS agreed to subordinate its lien for a payment of $120,000. Between the time the taxpayers purchased the house and the time they sought a second mortgage, they incurred significant federal tax debt and the IRS filed notices of federal tax lien. Very few second mortgage companies seek subordination of the federal tax lien in this situation, and we do not know why it happened here. By agreeing to subordinate the federal tax lien, in return for a payment, the IRS gave away its priority position in the home to the second mortgage lender.

Sometime after the creation of the second mortgage, a home fire occurred. Although the second mortgage lender required that the taxpayers insure their home for fire, it did not have itself named as the beneficiary of the insurance proceeds. Only the first mortgage lender was named on the policy. Because it was not named on the policy, the second mortgage lender held an equitable lien in the proceeds.

Prior to the fight over the insurance proceeds, taxpayers filed a chapter 13 petition in bankruptcy and subsequently converted the case to chapter 7. The insurance proceeds from the fire became property of the estate against which the IRS and the second mortgage company each claimed an interest. The parties filed cross motions for summary judgement seeking payment of the insurance proceeds. The parties did not dispute that liens of each attached to the proceeds but only who had the superior priority.

The second mortgage holder argued first that its equitable lien on the insurance proceeds resulted directly from its lien on the property to which the federal tax lien was subordinate. The IRS countered that though its lien was subordinate to the second mortgage holder’s lien on the home itself, that did not make its lien subordinate with respect to the insurance proceeds. It argued that the court must look to the timing of the attachment of the respective liens to the proceeds, in other words their choateness with respect to the proceeds. The second mortgage company, knowing that if the court framed the argument in this manner it might lose, argued that its claim was statutorily excepted from the choateness requirement pursuant to IRC 6323(c), a provision rarely litigated.

The court agreed with the IRS that the case involved the timing of the attachment of the liens to the insurance proceeds. It found that the liens attached simultaneously to the insurance proceeds. Based on V.J. Processors, Inc. v. Fireman’s Fund Ins. Cos., 679 F. Supp. 399, 401 (D. Vt. 1987), the court finds that the tie goes to the IRS in this situation. That result matches the result of a fight between the IRS and a judgment lien creditor as decided by the Supreme Court in United States v. McDermott, 507 U.S. 448 (1993).

The court explains that the second mortgage holder’s argument regarding IRC 6323(c) does not work because a home mortgage is not a commercial financing security. The purpose of IRC 6323(c) is to allow lenders to provide a line of credit. A line of credit would not work if the filing of a federal tax lien immediately gave the IRS priority over the lender, since the lender could not watch for the filing of a notice of federal tax lien every moment of the day. Essentially, this provision gives the lender a 45-day window to discover the filing of the federal tax lien and shut off the line of credit. The court correctly decides that this commercial lending provision does not apply to the circumstances of this case.

While holding for the IRS, the court notes the unfairness of the result to the lender resulting strictly because of the change in the interest securing the property from the real estate to insurance proceeds. Had the property been sold instead of destroyed, the second mortgage holder would have won any priority dispute. The court says:

While the statute does not offer relief to the non-governmental creditors in this case, from an equitable perspective there is something troubling about this commercial transaction, in which the facts indicate (i) the IRS subordinated its interest in the real property to induce the Joint Bank Lienholders to make mortgage loans to debtors in financial distress, (ii) the Joint Bank Lienholders paid $120,000 in consideration of that subordination, (iii) the Joint Bank Lienholders each then made a mortgage loan, apparently in reliance on the subordination agreement, and (iv) when the property that was collateral for their loans was destroyed, the IRS declared its subordination agreement did not apply to the proceeds of the collateral and proclaimed its lien usurped the Joint Bank Lienholders’ interest in those proceeds. This seems inconsistent with the Remaining Parties’ expectations and intentions, and creates a result dependent on whether the Oneida Property was reduced to proceeds or was in existence at the time the Remaining Parties sought to enforce their respective rights against it, and whether the Debtors fulfilled their contractual duties to the Joint Bank Lienholders. The Joint Bank Lienholders ask this Court to do equity by turning over the Insurance Proceeds to them. The IRS responds that federal law controls and establishes very clear criteria, which the Joint Bank Lienholders simply have not met, in order to have priority over the IRS’ federal tax liens.

Cold comfort for the lender whose mistake here was not to be named on the insurance proceeds but to rely on its equitable lien.  The case demonstrates the sometimes peculiar results that lien law can produce, as property interests create outcomes that logic might not have dictated.  Because of the financial situation of the taxpayers, the insurance proceeds may provide the only source of recovery, leaving the second mortgage lender out in the cold.

DOCUMENT ATTRIBUTES
Subject Areas / Tax Topics
Authors
Copy RID